A Payroll Tax Math Error Adds $5 Billion To The Deficit

Nothing gets lawmakers and pundits more outraged than government’s proverbial waste, fraud, and abuse. Nearly always, these stories involve spending. But taxes are hardly immune. One case of pure waste involves a simple math mistake that will cost the Treasury $5 billion in lost revenue over the next decade.

Much of this windfall goes to the highest income workers. A new report by my Tax Policy Center colleague Jim Nunns finds that a few of the very highest-paid business owners are enjoying a tax bonanza that exceeds $20,000-a-year. And worst of all, Congress has known about the problem for decades and never bothered to fix it.

Congress created this mess when it applied the wrong formula to the Social Security and Medicare payroll tax paid by sole proprietors and partners in law firms, private equity firms, and the like. The SECA (Self-Employment Contributions Act) tax is supposed to exactly parallel the better-known FICA tax, which is applied to employees. But, as it turns out, it doesn’t. And the result is that self-employed business owners pay less in payroll tax than employees earning exactly the same amount of money.

In an article first published in Tax Notes, Jim calculated this boondoggle reduces payroll taxes by about $100-a-year for a self-employed person making $100,000, about $500 for one making $300,000, and about $900 for a business owner making $500,000. If you pay yourself $1 million, you can save nearly $2,100 and if you’re getting $10 million, you pay $23,000 less in payroll tax than you should. That payroll tax savings is roughly half the median household income.

All because Congress made a simple math error. Here’s what went wrong:

The FICA payroll tax is divided into an employer share and a worker share. Employers pay 7.65 percent (6.2 percent for Social Security and 1.45 percent for Medicare), which is excluded from the worker’s wages subject to income tax. Workers pay an equal amount, plus an extra 0.9 percent Medicare tax, on wages over $200,000. The Social Security portion is capped at $117,000 in wages. The 1.45 percent Medicare tax applies to all wages.

The self-employed are supposed to pay an exactly parallel tax—half as an “employer” and half as “employee” (plus the extra 0.9 percent Medicare tax). But, thanks to a long-standing formula snafu (three mistakes, actually), they have not paid the right tax for years.

The basic error: Self-employment earnings need to be decreased to account for the exclusion of the employer share of FICA from wages. The SECA formula-writers messed up by making the deduction too large.

Take somebody making $100,000. If she is an employee, she and her firm each pay $7,650 in payroll tax for a total of $15,300. But if she is self-employed, her comparable earnings are $107,650 (wages plus the “employer” share of the payroll tax). Applying the 7.65 SECA deduction reduces her taxable earnings to $99,415, thus her tax is just $15,210.

To correct for this, the formula needs to reduce the SECA deduction to 7.1064 percent, so taxable earnings are the same $100,000 for a sole proprietor or partner as they are for an employee.

But the current law for the self-employed allows the full deduction of 7.65 percent—not only for earnings below the Social Security cap but, remarkably, even for earnings subject only to the 1.45 percent Medicare tax.

On top of all that, the current formula also incorrectly converts the Social Security wage cap for the self-employed.

There are some trade-offs. Because a sole proprietor is paying a smaller Social Security payroll tax, she’ll also get a slightly lower benefit when she retires. So by paying the correct tax, she’d get a bit more in old age. Plus, since she can deduct her "employer" share of payroll tax from earnings subject to income tax, she’d also enjoy a larger deduction for paying the correct amount. But those don’t come close to offsetting the windfall.

Congress should have fixed this error years ago but never bothered. House Ways & Means Committee chair Dave Camp’s tax reform would correct the mistake, but that measure is going nowhere.

Lawmakers love to express outrage when confronted with wasteful government spending. Let’s see if they do anything about a costly error when it comes to taxes.

5Comments

Michael Bindner :: 4:36 am on July 2nd, 2014:

That Congress has not corrected the math error is no shock. The people benefiting the error write check for elections, probably all of them actually.

Anyway, I am for a bigger fix – lower the Self Employment Tax attributable to the employee contribution – as well as the employee contribution itself, thus lowering payments while replacing the employer contribution with a VAT or VAT-like net business receipts tax (the latter is for personal retirement accounts) the long and the short of it being equal crediting of this tax to employees, regardless of wage and not ceiling to the tax. Sadly, the people writing the checks really won’t lilke this one – not for the loss of wealth but the loss of power.

Janet :: 10:51 am on July 2nd, 2014:

Interesting, but tax policy is so convoluted that I am not sure it means much. I am sure there are some fat cats benefiting, but most self-employed people are like me, not making that much. And a lot of ways I get treated worse than employees come to mind. For example, I don’t get to deduct all my health insurance and pay for it out of my already taxed income. Employees don’t see any of that as income, and mine amounts to about $10,000 a year. The $60 or $70 dollars of benefit from self employment tax is trivial compared to that. They need to clean up the whole sticking mess, but even if they did, it would be convoluted again in no time. It’s so complex even my accountant isn’t sure about a lot of things, many of which are being challenged in court. And I have to pay my accountant around $3,000 to deal with this mess (business & personal), which is a big percentage of my income, plus spend endless hours on it. I consider all of this part of the taxes I am paying because it is mostly unnecessary.

Solomon Jurdiss :: 12:03 pm on July 2nd, 2014:

let’s just reduce the Self Employment tax and eliminate the home mortgage interest deduction to pay for it. Why is debt encouraged with this deduction anyway?

You’re the Boss Blog: Today in Small Business: Speed-Dating | News In Marketing :: 2:51 pm on July 2nd, 2014: